Accounting concepts are the building blocks of any business. Mastering these concepts can help you become a competent leader. Read on!
Overview:
Important Accounting Concepts – Accounting is the systematic recording and reporting of financial transactions in a manner that allows for appropriate analysis, evaluation, and communication. It is an essential component of any business operation because it provides the information necessary to analyze and evaluate past performance and predict future results. Hence the importance of accounting in a business operation is utmost. We can say that accounting is the most important subject since it has a direct bearing on how businesses perform. Due to this, understanding and using accounting principles correctly is imperative to take your business to new heights.
What Are Accounting Concepts?
In simple words, accounting concepts are ideas, conditions, and assumptions on which businesses or organisations record their financial transactions & organise the bookkeeping process. It allows a business to interpret & integrate the complete financial transaction into the accounting process.
5 Important Accounting Concepts and Principles
The five key accounting concepts and principles below will provide a solid foundation from which you can start building a sound knowledge of accounting.
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Accrual Accounting vs. Cash Basis Accounting
In accrual accounting, the income and expenses of the company from its various activities are recorded when they occur instead of waiting for the payment to be actually received or paid. In other words, accrual accounting records revenue and expense items right away.
Cash basis accounting, on the other hand, only records income and expenses at the time they are paid or received. For example, if a business sells goods for ₹100, but it takes two weeks to get paid, the cash basis accounting would record the sale as taking place in the second week instead of recording it immediately.
Most companies use some version of accrual accounting because it’s easier to understand But there are advantages and disadvantages to both methods.
One advantage of accrual accounting is that it allows you to quickly see changes in your company’s financial position over time. Also, this method makes it easy to compare your company’s current performance to prior years.
Cash basis accounting is used more frequently by small businesses that deal only with cash transactions, such as retail stores or restaurants.
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Consistency
Consistency refers to the regularity with which a business reports its financial reports. A consistent history of reports improves the reliability of the financial information provided by the company.
The consistency of a business is determined by many factors, including the way in which the company accounts for income and expenses, the choice of accounting methods for different types of transactions, and the frequency of internal audits.
For instance, if the company consistently uses a cash basis accounting system, it must reconcile its balance sheet to its bank account on a daily basis. If it always chooses the same accounting options for its different lines of business and uses the same terminologies, it will have a better ability to analyze its results over time. Otherwise, it becomes difficult to compare various records over time.
The importance of consistency goes beyond just the accuracy of the numbers; it also has an impact on investor confidence.
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Going Concern
Going concern is an accounting term that indicates the belief that an organisation will continue operating indefinitely. To determine the going concern status, an accountant can look at the company’s assets, liabilities, and net worth, among other factors.
For example, if a company does not generate enough sales to meet its expenses, it probably is not going to continue doing business for a long time. However, if it anticipates closing in the near future, it should not issue shares of stock to raise money for expansion. This is because the business would not be able to generate sufficient cash flow to cover its debt obligations, which could result in them being forced into bankruptcy.
In case a business expects to continue functioning for several more years, then it would be reasonable to assume that it will be able to pay its debts. Therefore, it is one of the most important accounting principles because it determines whether a company is financially stable. If a company cannot continue operating, it will eventually go bankrupt, so accounting professionals need to be very careful.
So, how to determine if a company can run for an indefinite period? There are mainly two ways.
- If the company has assets greater than its liabilities, even if it does not pay dividends to shareholders, it is probably in good standing.
- The other method is to analyze the company’s profitability. If the company is making money, then it is likely to continue doing so. The fact that it may have gone through a rough patch in the past does not mean that it won’t rebound.
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Conservatism
Conservatism is simply defined as providing realistic assumptions and estimates in your calculations. It requires an accounting entry that should match what is actually happening in reality. In short, this concept refers to the difference between the actual number and the reported number.For example, if a company reports ₹10 Crores in revenue but only receives ₹9 Crores, the discrepancy is ₹1 Crore. Conservatism requires that the reported numbers match the actual amounts.So, why is conservatism important? There are several reasons for it.Generally, internal information is usually biased toward the company’s viewpoint. For instance, you might think that the company is going to grow 20% next year when the reality is that it’s only going to grow by 10%.In addition, your investors want to know the truth. They want to know that you are not exaggerating earnings and revenues. If you present inaccurate figures, investors will lose trust in you and your company. In the worst-case scenario, they will sell their stocks.
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Economic Entity Assumption
This principle states that a business entity exists separately from its owners. An economic entity is distinct from its owners and managers, and its operations do not affect the personal wealth of its owners. For example, if a company owns 100 shares, it is a separate legal entity from those who own the shares. Similarly, if a company has ₹1Crore in assets and ₹50 lakhs in debt, it is a separate entity from its shareholders. Its creditors don’t have the right to collect from the company’s owners.An economic entity is considered to be a separate entity from its owners and managers because it is a legally recognised business. It is treated differently under the law, which enables its owners to make decisions without worrying about lawsuits.Furthermore, it is possible for companies to get funding from financial institutions and banks. They can issue bonds, notes, and debentures to raise capital. These funds give the lenders a claim on the assets of the company.
Conclusion
We hope this article about some of the most crucial accounting concepts with examples has helped you to get deeper insights into the basic financial accounting concepts. Having a thorough knowledge of these concepts is mandatory for anyone who wants to succeed in business.
If you are a business owner who doesn’t want to go through the hassles of accounting, our expert team at Vakilsearch can provide seamless accounting & bookkeeping services that your business needs.
